US CPI inflation accelerated substantially further in June, at 9.1% yoy, the highest since November 1981, from 8.6% in May, significantly above expectations for 8.8%. The sequential momentum was sharp (+1.3% mom sa) and price pressures were broad based.
The upside surprise initially led to speculation that the Federal Reserve may hike the federal funds rate by 100 bps (1%) on July 27th to a range of 2.5% - 2.75% instead of 75 bps. The respective probability, implied by Fed Fund futures contract prices, briefly reached 80% following the CPI report (July 13th), before settling down to 30% later on.
Attention now turns to the ECB meeting on July 21st. Recent officials’ commentary are roughly in line with the ECB adhering to its stated intention to increase the policy interest rates, probably by 0.25%. Importantly, specifics on the new “anti-fragmentation” tool are expected, even if full details and finalization come later on. ECB’s forward guidance will also be monitored, with the door for larger rate hike increments in subsequent meetings expected to be left wide open, as policymakers are navigating through elevated uncertainty for the economic outlook.
Indeed, the euro area economy is heavily exposed to risks stemming from the war in Ukraine, particularly in the event of a total cut in natural gas flows from Russia. The European Commission downgraded its projections for GDP growth by 0.1 pp to +2.6% for 2022 and by 0.9 pps to +1.4% for 2023. On the other hand, the EC revised upwards the respective ones for inflation by 1.5 pps to 7.6% for 2022 and by 1.3 pps to 4.0%in 2023.
Attention also turns to the natural gas flows saga from Russia to Europe (42% of total gas imports including LNG in 2021), with the maintenance period for the Nord Stream 1 pipeline, being set to end on July 21st. The extent to which the flows will be restored, will be closely monitored. Overall, natural gas flows from Russia to Europe from all pipelines have declined considerably to circa 200 million cubic meters per day from 450 million cubic meters per day on average in 2021 and are likely to remain at high risk in the foreseeable future.
The euro exchange rate has depreciated due to the risk of a serious blow to euro area economic activity in the event of a total cut of natural gas flows from Russia. The US Dollar benefitted from the widening of interest rate differentials, as well. As a result, the euro lost 0.9% wow against the US Dollar, to $1.008 (-2% MtD, -10% YtD), spending most of the week virtually at absolute parity for the first time since December 2002, before recovering to $1.02 in the start of the current week.
The Italian political crisis intensified, with PM Draghi handing his resignation, albeit President Mattarella rejected it. Still, the “national unity” government continues to hang by a thread, as the wide support from political parties appears to have been lost.
PM Draghi is due to address the Italian parliament on Wednesday to clarify his intentions, particularly on whether he will remain in office even with a narrower political support. If not, either a new government scheme will be sought from the current legislature, or general elections will be brought forward (from no later than June 1st 2023), likely to early-October. Italian assets lost ground across the board.